Author: Ted Ballantine

On March 5, 2013 the Dow Jones closed at over 14,000—a then-record high for the major index. One month later, it pushed the mark further and closed at 15,000; by late November, the Dow had eclipsed 16,000 for the first time in history. Now, in June 2014, the index sits just a few points away from 17,000.

The S&P 500 has come along for the ride, closing with record highs 19 times in 2014 alone.

You’d be forgiven for assuming that the nation’s public pension funds—all of whose health are intimately tied to equity markets—are enjoying the spoils of this market expansion more than anyone. But the numbers tell a different story.

Between 2009 and 2013, while the S&P 500 saw 188 percent gains after reaching an all-time low, public pension funds across the country saw their average funded ratios decrease—from an average of 79 percent in 2009 to 72 percent in 2013.

You don’t need to be a statistician to see the problem here: equity values have skyrocketed in the last 5 years. But pension funds, at least on the surface, have not benefited. In fact, they’ve become less healthy on the whole.

Are the numbers lying? No, according to a new report from the Center for Retirement Research. But the numbers aren’t telling the whole story either, and there are a few explanations for this pension paradox.

First, it’s important to note some significant changes recently adopted by one of the world’s largest funds, the California Public Employees Retirement System (CalPERS). In 2012, on the recommendation of its actuaries, the fund lowered its discount rate to 7.5 percent from 7.75 percent. More recently, the fund began assuming larger benefit packages for a segment of its participants and longer life spans for all of them.

Those changes brought CalPERS’ funded ratio down from 83 percent in 2012 to 69 percent in 2013. But it doesn’t explain the lack of funding status improvement across the country.

For a real explanation, we turn to an accounting technique called asset smoothing, which takes annual fluctuations in the stock market and averages them over a period of (typically) 5 years.

The purpose of the policy is to keep funds focused on the long-term and to negate the panic and short-term thinking that comes with major negative fluctuations in the market.

But the flipside is the phenomena we’re witnessing now, where today’s strong returns are weighted down by bear markets of the recent past. So, despite large market gains in the last 4 years, the “smoothed” value of pension plan assets only rose 2 percent in 2013.

As the CRR report notes, 2014 is a big year for pension funds. The 2009 market losses will rotate out of the smoothing calculations, and that alone could increase the aggregate funding status of US public plans to 75 percent, according to CRR estimates.

New GASB standards have also begun kicking in, meaning many funds will begin reporting the market value of their assets rather than the smoothed values. That could bring plans’ funded ratios to around 80 percent on average, says the CRR.

If that happens, the burden will be on state and local governments to pay their annual required contributions (ARC), in full, into their systems. All too often, they shirk this responsibility during the “good” times. Unfortunately, we’re seeing a bit of that mentality surface again.

The trend is clear: during market contractions (the tech bubble in 2001 and the financial crisis in 2008) governments scramble to cover funding shortfalls and are willing to pay nearly their entire ARC. But when the market rights itself, they are content to watch their required contributions taper off and let market gains cover the ensuing shortfall.

Since the financial crisis, governments have slipped back into old habits. Still, we have to give credit where credit is due: governments paid more of their ARC’s in 2013 than they did in 2012. But you know the old saying: one time is an accident, two is a trend. Hopefully, 2013 wasn’t an accident. Whether it’s the start of a trend, however, remains to be seen.

This article is based on data presented in a June 10, 2014 report by the Center for Retirement Research. Read the full report here.

Photo by Andreas Poike via Flickr CC License

In 2009, the Kentucky Retirement System (KRS) made two bold investments. The first: a $100 million investment in a newly formed hedge fund called Arrowhawk Durable Alpha.

Next, the System placed $24 million in another, more established hedge fund—Camelot Group.

The investments were supposed to produce big returns and lift some weight off the shoulders of Kentucky’s woefully underfunded retirement system. But the reality was quite the opposite.

Less than three years after KRS’ initial investment, Arrowhawk Durable Alpha Fund failed and closed.

Around the same time, the founder and then-head of Camelot Group, Lawrence E. Penn III, was indicted on 32 counts of various fraud charges—he’d allegedly stolen more than $9 million of his investors’ money, according to prosecutors.

The KRS was eventually able to recover the $100 million it had invested in ArrowHawk. But when it came to Camelot Group, they weren’t so lucky.

That’s because the SEC froze Camelot’s assets in January, making it became impossible for KRS to withdraw its money.

Not that it mattered: predictably, Camelot hadn’t managed its investor’s money very well.

According to KRS documents, its initial investment of over $23 million was valued at a mere $12 million as of March—a 48 percent loss.

This string of poor investment decisions by KRS hasn’t gone unnoticed. Last week, the City of Fort Wright filed a class-action lawsuit against the Kentucky Retirement System, seeking restitution for the increased contributions required from the city due to investment losses associated with the ArrowHawk and Camelot funds, among others:

In its lawsuit, filed in Kenton Circuit Court, the city of Fort Wright said KRS violates the law with risky investments in hedge funds, venture capital funds, private equity funds, leveraged buyout funds and other “alternative investments” that have produced small returns and excessive management fees, possibly in excess of $50 million over the last five years.

KRS, which is publicly funded, is legally required to stick with relatively safe common stock and bond investments, at least with the local government pension and retiree health care money that it manages through its County Employees Retirement System, the city said.

“Some of the alternative asset investments selected by the board were start-up funds with virtually no track record,” attorneys for the city wrote in the suit.

Fort Wright wants a court order keeping its money out of alternative investments; an accounting of where its money has gone so far, including the disclosure of all investment management contracts; and restitution in excess of $50 million, to compensate it for allegedly improperly paid fees.

KRS manages investments for the two largest state-level and local-level pension systems: the Kentucky Employee Retirement System (KERS) for state employees, and the County Employees Retirement System (CERS), for local employees.
One of Fort Wright’s goals in filing the suit is to force KRS to separate its investments into two pools: one for KERS investments, and the other for CERS investments. According to Fort Wright attorneys, the CERS pool would involve less risky investments.

You only need to glance at the numbers to see the motivation for the proposed separation: KERS is dangerously underfunded (23 percent funded ratio), while CERS remains healthier by comparison (60 percent funded ratio).

That’s a direct result of local governments making their required contributions, in full, into the system. The state government, on the other hand, has consistently skimped out on such payments. This chart from Ballotpedia tell the whole story:

The dire health of KERS means money is more likely to be allocated toward riskier investments with promises of higher returns. When those returns don’t materialize as expected, however, the loss must be offset somehow. That burden unfairly falls on the cities and counties of Kentucky, argues Fort Wright’s lawsuit.

Indeed, ballooning pension costs were the scapegoat when the town of Covington laid off 22 employees in 2011. From the Cincinnati Enquirer:

The city’s pension costs accounted for $6.2 million out of its $47 million budget this year, Covington City Manager Larry Klein said. That’s double what it was 10 years ago, he said. Health care cost the city an additional $6 million.

“Imagine a private business having 25 percent of its revenue spent on pension and health care, not paychecks,” Klein said. “That is a drag on the budget. It means less of everything, less reinvestment, less infrastructure and less services.”

Fort Wright, and by extension CERS, want no part of that game.

“It’s a sinking ship over there,” said [Jerry] Miller, [a Louisville Councilman]. “My argument is, let’s cut our losses and separate CERS from the rest of the system and let CERS be managed more prudently, using plain-vanilla investment techniques instead of these risky equity funds that have enormous fees.

Attorneys for Fort Wright said they filed the lawsuit on behalf of all cities and counties in the state, but it remains to be seen whether others will take up arms.

Picture courtesy of PurpleSlog via Flickr Creative Commons License